MACRO AND FINANCIAL MARKETS: The memory of an elephant?
Karim M. Abadir
Macroeconomic and aggregate financial series share an unconventional type of nonlinear dynamics. Existing techniques (like co-integration) model these dynamics incompletely, hence generating seemingly paradoxical results.
To avoid this, we provide a methodology to disentangle the long-run relation between variables from their own dynamics, and illustrate with two applications.
First, in the forward-premium puzzle, adding a component quantifying the persistent nonlinear dynamics of exchange rates yields substantial predictability and makes the forward-premium term insignificant. Second, S&P 500 grows in a pattern of momentum followed by reversal, forming long cycles around a trend given by GDP, a stable non-breaking relation since WWII.
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